Ways of expressing forward rates

In addition to the direct or indirect quotation, forward exchange rates can be expressed in one of three ways. First, the forward rate can be quoted as an outright rate — i.e. the actual forward rate of exchange.

Secondly, it can be quoted as forward exchange margins or points (also called swap rates). These latter are either discounts or premiums depending on the interest differentials between the home and foreign currency. If the foreign currency interest rate is higher than the home currency interest rate, the foreign currency will be at a forward discount to its spot rate. If, on the other hand, the foreign interest rate is below the home currency interest rate, the foreign currency will be at a forward premium to its spot value. The magnitude of the discount or premium is dependent upon the size of the differential in home and foreign interest rates and the time to maturity of the forward contract.

With indirect quotes, discounts are added and premiums deducted from the spot rate to calculate the outright forward rate. In the case of direct quotes, the discounts are deducted and the premiums added to the spot rate to arrive at the outright forward rate.

Thirdly, the swap rates can be quoted in percentage terms. This method is sometimes employed to facilitate comparison with the interest rate differential between two currencies. Examples of how the outright forward rate and the forward margins are determined will now be given.

The determination of forward exchange rates

We have shown in the previous section that forward exchange rates differ from spot rates by the amount of the forward margin. This section explains why those differences occur and thereby explains the determination of forward exchange rates and the pricing of forward exchange contracts.

Currency can be considered as a carryable asset that pays a continuous and known distribution. This is because it can be purchased in the spot market and invested in the foreign risk-free asset. Consequently, the hedging transaction for the sale of forward currency will be to borrow domestic currency, buy the foreign currency a the current spot rate and place the funds in the foreign risk-free asset. Although in reality they will usually be placed in a eurocurrency deposit, earning the foreign rate of interest, the principle is clear.

This strategy is analogous to the cash and carry arbitrage found in the futures markets. Remembering that the net cost of carry consists of storage costs, transportation costs and financing costs, then the storage costs are the foreign currency interest earnings, the financing costs are the domestic interest costs and the other costs are insignificant in respect to currencies. Consequently, the net cost of carry for currency forwards, and for futures, is determined by the interest rate differential. Thus the forward exchange rate will be equal to the spot rate plus the net cost of carry, which is equal to the difference between the domestic and foreign interest rates.

More about: Inside of the foreign exchange market continue…

• Inside of the foreign exchange market
• Using currency options to manage risk
• Applications of swaps to risk management
• Foreign Currency Futures
• International Investing Concerns and Limitations Part 2
• Basket options
• Regulation of Managed Futures Funds in Europe Part 7
• Valuing American options on futures contracts
• Key Points and bottom lines in Currency Forward Rates
• Average rate options

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